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Nov 10, 2008

Carbon Price Collapse: Is An ETS The Best Way Forward

Carbon crash hits Europe's emission trading schemeCarl Mortished November 06, 2008WHILE you were distracted by crashing banks and clashing US senators, you may have missed a small environmental earthquake.The price of carbon has collapsed.In only three months, life has become a lot cheaper for polluters. The financial cost of warming the planet has plummeted in Europe's emissions trading system (ETS) and the effectiveness of such a volatile market mechanism in curbing carbon is being questioned.You may recall that the ETS is a mechanism to encourage businesses to reduce their carbon output. Europe's larger companies are allocated permits to emit CO2, and these allowances, called EUAs, can be traded on exchanges.Companies that emit less CO2 than their allocation can sell EUAs for cash, but inefficient polluters must buy EUAs or face financial penalties.The idea is that a shortfall in EUAs allocated by governments will cause the carbon price to rise, stimulating investment in carbon reduction.It's a market solution to pollution, but this carbon market is showing a distressing tendency to behave like most financial markets -- hysterically. In July, the right to spew out one tonne of CO2 from a chimney would have cost a power generator E29.33, but yesterday it could be bought for only E18.25 ($34.14).The sudden collapse of the carbon price mirrors the rout in the wider commodity markets. Carbon peaked in July, its price summit occurring within 10 days of the peak in the crude oil price.Since then, everything from steel to potash has been tumbling and you might think it unsurprising that carbon has tracked the general retreat. Hedge funds and other financial investors dabbled in EUAs as they fiddled with palm oil and soya.The rush to convert hedge fund investments into cash and US Treasury bills has resulted in rapid closure of positions on various carbon exchanges.Obviously, the credit crunch has little to do with underlying demand for EUAs in a market artificially created by regulators in Brussels. However, economic downturn and recession will affect the carbon market.Less industrial and transport activity implies fewer emissions, so the shortfall between actual emissions and allowances will shrink, reducing demand for EUAs, thereby causing the carbon price to fall.Some analysts reckon the carbon price has fallen far enough, even allowing for a recession. IDEAcarbon, a rating agency, has halved its estimate of the allocation shortfall from 206 million tonnes of carbon to 98 million tonnes in 2008 and 83 million tonnes in 2009.The point is that there will still be a shortfall. Societe Generale reckons EUAs will find a floor at E15 per tonne before rebounding next year into the low E20s per tonne.Maybe so, but the ETS is making a mockery of Europe's stumbling attempts to lead the world with a market-based carbon strategy. It is causing irritation and frustration to the armies of advisers and investors who seek to cajole utilities into big investments in carbon reduction.James Cameron, the director of Climate Change Capital, a financial adviser and fund manager, said: "The whole purpose of the ETS is to take carbon out. It's not there to benefit funds or to support trading."It's those "speculators" again -- the ones that pushed the oil price up the hill to $US147 a barrel and then let it roll back to $US60.It is a terrible irony that one aim of creating a carbon market was to provide a measure of certainty to the energy industry in estimating the future price of carbon for the purpose of planning investments in new power generators.Estimates of the price at which carbon capture and storage technology might be economically viable vary between E40 and E60 a tonne. Suffice it to say we are nowhere near these levels.More political action is needed, Cameron says, with smaller carbon allocations by governments to industry, which would entail a much bigger shortfall in EUAs and a much higher carbon price.It is a moot point, however, whether there is political appetite in Europe for such a burden. The European Commission is already struggling to create a coalition of the willing to do battle with carbon emissions, and Italian Prime Minister Silvio Berlusconi has made clear his preference for a gentle regime.It's a measure of the speed at which politics moves in response to market prices that the green agenda has almost vanished from media political chatter.Carbon's falling price spells companies going bust, the loss of jobs and the shredding of political reputations. Over the next year, no politician with re-election hopes will back a policy that would triple the price of carbon for industry and raise consumers' energy costs. There is a wider question about the ETS that must be addressed, and that is whether it is a sensible mechanism to regulate carbon.Price volatility, whether in oil, gas or coal, is a huge burden for the energy industry. Violent movements in price cause financial damage and promote short-termism -- the sort of thinking that is anathema to the climate change lobby.If there is to be any prospect of a serious cut in carbon, there must be stability in carbon pricing. Although a financial market gives useful price signals, it cannot provide stability.Only a stable regulatory regime can provide certainty, but that means carbon taxes and a policy leap that no one is yet willing to make.

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